Coinbase earnings reports carry weight because the U.S. cryptocurrency exchange commands material market share in a budding portion of the digital economy. Additionally, it’s an active startup investor and a key data point in determining the current health of the crypto market. Naturally, TechCrunch was all over its recently released financial data, pulling out a few key takeaways from the mix.
However, in the wake of Coinbase’s Q2 2022 earnings cycle, its regulatory disclosures contained in recent filings with the U.S. Securities and Exchange Commission have garnered attention, so this morning we’re digging in a bit more.
Regulatory risk is always something to consider when we discuss financial technology companies. Any business dealing with money in motion has to abide by a large and complicated set of rules that have been written over time in an effort to help a nation’s financial markets operate smoothly, with minimal fraud and a lack of erratic volatility.
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However, because the technology market can advance faster than government regulations, companies operating at the forefront of changes to financial technology can wind up in a regulatory gray area. This creates a gap between what the government has sorted out and what the market is actually up to. That’s where we can spot regulatory risk, and that zone of uncertainty contains billions and billions of dollars of economic activity.
In the wake of the United States government’s recent indication that it views a number of crypto assets as securities, the question of how crypto exchanges and related entities can operate in the United States — a huge market for digital assets and tokens — on the right side of the law comes into focus.
In its 10-Q filing, Coinbase reports the following (emphasis: TechCrunch):
The Company has received investigative subpoenas and requests from the SEC for documents and information about certain customer programs, operations, and existing and intended future products, including the Company’s processes for listing assets, the classification of certain listed assets, its staking programs, and its stablecoin and yield-generating products. Based on the ongoing nature of these matters, the outcomes remain uncertain and the Company cannot estimate the potential impact, if any, on its business or financial statements at this time.
The Company believes the ultimate resolution of existing legal and regulatory investigation matters will not have a material adverse effect on the financial condition, results of operations, or cash flows of the Company. However, in light of the uncertainties inherent in these matters, it is possible that the ultimate resolution of one or more of these matters may have a material adverse effect on the Company’s results of operations for a particular period, and future changes in circumstances or additional information could result in additional accruals or resolution in excess of established accruals, which could adversely affect the Company’s results of operations, potentially materially.
The “investigative subpoenas” portion of that note, and the breadth of the inquiries (“processes for listing assets, the classification of certain listed assets, its staking programs, and its stablecoin and yield-generating products”) drew a fair amount of media attention, as noted above.
While Coinbase is clear in its wording above — and on its corporate blog regarding the securities issue — that it believes it is not in material danger due to the regulatory scrutiny, as a public company, it has to talk about what could go wrong. So let’s take a look at that.
First, the following excerpt from Coinbase’s “risk factors” section details part of the risk that it faces, namely that future regulation and its impacts are uncertain:
Because we have offered and will continue to offer a variety of innovative products and services to our customers, many of our offerings are subject to significant regulatory uncertainty and we from time to time face regulatory inquiries regarding our current and planned products. [ … ] The regulatory treatment of fiat-backed stablecoins is highly uncertain and has drawn significant attention from legislative and regulatory bodies around the world. [ … ] Certain products and services offered by us that we believe are not subject to regulatory oversight, or are only subject to certain regulatory regimes, such as Coinbase Wallet, a standalone mobile application that allows customers to manage their own private keys and store their crypto assets directly on their mobile devices, may cause us to be deemed to be engaged in a form of regulated activity for which licensure is required or cause us to become subject to new and additional forms of regulatory oversight. We also offer various staking, rewards, and lending products, all of which are subject to significant regulatory uncertainty, and could implicate a variety of laws and regulations worldwide. For example, there is regulatory uncertainty regarding the status of our staking, lending, rewards, and other yield-generating activities under the U.S. federal and state securities laws.
The securities question in particular receives a pile of words from Coinbase. Here’s how the company discusses the matter (again, emphasis: TechCrunch):
The SEC and its staff have taken the position that certain crypto assets fall within the definition of a “security” under the U.S. federal securities laws. The legal test for determining whether any given crypto asset is a security is a highly complex, fact-driven analysis that evolves over time, and the outcome is difficult to predict. The SEC generally does not provide advance guidance or confirmation on the status of any particular crypto asset as a security.
Regarding the cryptocurrencies recently cited as securities by the SEC, Coinbase adds the following:
These SEC charges allege that nine crypto assets involved in this matter are securities under federal securities laws, seven of which we listed on our platform: AMP, RLY, DDX, XYO, RGT, LCX, POWR. Despite the SEC being the principal federal securities law regulator in the United States, whether or not an asset is a security under federal securities laws is ultimately determined by a federal court. No court ruling has yet been made in connection with these seven crypto assets.
So if they really are securities, what does that mean for Coinbase, which facilitated their trading? Again, the company (emphasis: TechCrunch):
The classification of a crypto asset as a security under applicable law has wide-ranging implications for the regulatory obligations that flow from the offer, sale, trading, and clearing of such assets. For example, a crypto asset that is a security in the United States may generally only be offered or sold in the United States pursuant to a registration statement filed with the SEC or in an offering that qualifies for an exemption from registration. Persons that effect transactions in crypto assets that are securities in the United States may be subject to registration with the SEC as a “broker” or “dealer.” Platforms that bring together purchasers and sellers to trade crypto assets that are securities in the United States are generally subject to registration as national securities exchanges. [ … ]
Regardless of our conclusions [regarding whether the assets in question are securities], we could be subject to legal or regulatory action in the event the SEC, a state or foreign regulatory authority, or a court were to determine that a supported crypto asset currently offered, sold, or traded on our platform is a “security” under applicable laws. As discussed above, the SEC brought an enforcement action in July 2022 against a third party that alleges that seven crypto assets trading on our platform are securities. Such enforcement action may increase the risk that the SEC decides to bring an enforcement action against us for facilitating trading in these crypto assets on the basis that our platform is not registered as a national securities exchange or ATS.
The risks thereof are not small:
[W]e could be subject to judicial or administrative sanctions for failing to offer or sell the crypto asset in compliance with the registration requirements, or for acting as a broker, dealer, or national securities exchange without appropriate registration. Such an action could result in injunctions, cease and desist orders, as well as civil monetary penalties, fines, and disgorgement, criminal liability, and reputational harm. Customers that traded such supported crypto asset on our platform and suffered trading losses could also seek to rescind a transaction that we facilitated as the basis that it was conducted in violation of applicable law, which could subject us to significant liability. We may also be required to cease facilitating transactions in the supported crypto asset other than via our licensed subsidiaries, which could negatively impact our business, operating results, and financial condition. Furthermore, if we remove any assets from trading on our platform, our decision may be unpopular with users and may reduce our ability to attract and retain customers, especially if such assets remain traded on unregulated exchanges, which includes many of our competitors.
Coinbase is acting as a bellwether for the U.S. crypto market; how it navigates the above issues will carry great import for smaller companies in the decentralized world, including hundreds of startups and tens of billions of dollars worth of invested capital. If Coinbase, which is actively lobbying its case, winds up on the wrong end of coming regulations regarding digital assets, it could be harmed — but other companies could be in even more trouble.
Why? Because Coinbase is both a crypto company at scale and a public company, meaning that both sides of its house are in order — a crypto company at scale has to have its technology sorted, and a public company must be run according to certain clear standards. Startups, smaller in scale and not under the rules of public-company status, may be ill-equipped to navigate an increasingly tight regulatory climate for crypto.
What’s my take? That some digital assets are securities, and while Coinbase is correct that more regulatory clarity is required, I think that more digital assets are securities than the company allows. The question is how hard the SEC may come down on Coinbase if it does decide on a regulatory framework that contrasts with the company’s views. If Coinbase is allowed to adapt its operations in that case, without massive penalty from the government, it would be something akin to the best case of the worst cases facing the company. A worse outcome would be an unfavorable regulatory outcome and huge penalties. The best for Coinbase, of course, would be regulatory vindication.
The ball is in the SEC’s court. More when some of the hypotheticals that Coinbase detailed above become on-the-ground facts.